BearBull Group Research: Positive Outlook for the Eurozone
BearBull Global Investments Group (DIFC)
BearBull Global Investments Group is a leading independent Swiss wealth advisory firm based in the DIFC
Key Points:
The rebound in the first quarter should continue in 2024
The European economy narrowly avoided a predicted recession in the second half of 2023, thanks to a stagnant GDP (0%) at the end of the year. The reported growth for the first quarter of 2024 (+0.3%) indicates a stronger European economy resuming growth, marking the best quarterly performance since September 2022. This improvement allows the eurozone GDP to show a +0.4% annual growth. This early-year rebound was driven by solid consumer spending and robust export performance. The positive trend in external trade was the main contributor to the economic recovery, adding +0.9% to the overall result, while the positive contribution from consumption was limited to +0.1%. Inventories and investments, however, pulled down the overall result for all countries.
Regionally, most countries recorded positive growth rates, with only three exceptions: Denmark (-1.8%), Estonia (-0.5%), and the Netherlands (-0.1%). Among the major eurozone countries, Germany (+0.2%), France (+0.2%), and Italy (+0.3%) experienced limited positive growth, while Spain (+0.8%), Portugal (+0.8%), and Italy (+0.7%) benefited from a better economic environment. The eurozone avoided recession due to higher-than-expected growth in the four largest economies. Germany's recovery, though fragile, was a welcome development after a -0.5% decline in the previous quarter, contributing to the overall +0.3% result.
The European economy has certainly passed the nadir of its growth cycle, as indicated by the trend reversal observed in Germany. It can now rely on several positive factors and developments to anticipate a strengthening of activity in the coming months. Weak domestic demand has been one of the causes of the lack of GDP growth due to the decline in household purchasing power in the still-present inflationary environment and the rise in interest rates over the past few quarters. However, there is a noticeable drop in inflation indicators, both with and without energy and food, which is expected to continue, approaching the ECB's target of +2%.
The first signs of easing interest rates are emerging, as the European Central Bank (ECB) pivoted its monetary policy in June by lowering its key rates for the first time after two years of restrictive policy. A new cycle of monetary easing will quickly impact yield curves and financing costs for households, businesses, and public authorities.
Return to growth at a reduced pace
The European Central Bank's forecast for GDP growth in 2024 has been raised from +0.6% to +0.9% (the European Commission's forecast is +0.8%), which suggests a decline in momentum in the coming quarters compared to the results already recorded in the first quarter of 2024. However, we believe the European economy will benefit from a faster-than-expected adjustment in inflation and be supported by the announcement of a more accommodative monetary policy. The continued decline in inflation will reduce the pressure on household real incomes, directly enhancing their consumption capacity. The decrease in interest rates will also have an additional positive impact on household and business confidence, stimulating demand. In the coming months, domestic demand is expected to strengthen through a resurgence in private consumption and a revival in investments.
Our central scenario for the second half of the year now favours a progression in the consumption dynamic, supporting a GDP increase of +0.3% per quarter until the end of the year. On an annual basis, the real GDP of the eurozone could therefore show a rise of +1.1%.
However, the beginning of the second quarter seems to have been slightly weaker than expected in terms of industrial production, which slipped by -0.1% and -3% year-on-year. This result casts a shadow over the positive outlook estimated for the overall GDP of the second quarter. Nevertheless, our economic recovery perspectives are rather supported by better performance in the services sector and consumption, which should be sufficient to sustain the expected progression.
Leading indicators remain uncertain
The latest publications of the PMI leading indicators for June indicate continued economic weakness, particularly due to challenging conditions in the manufacturing sector. The manufacturing PMI plunged in June to 45.8 after a brief recovery in May to 47.3. The manufacturing PMI remains well below the growth threshold of 50, which it last exceeded in June 2022, two years ago. Conditions are still quite different for the services sector, which remains above 50, suggesting a probable recovery in activity despite a decline in June from 53.2 to 52.8. The composite indicator stabilized in June at 50.9, remaining above the growth threshold.
The PMI indicators suggest that the eurozone economy is certainly in a phase of moderate economic recovery, supported by the services sector, but the recovery remains fragile and modest.
In Germany, the leading indicators show a relatively positive picture with a composite index of 50.3, supported by developments in the services sector, but still weighed down by a challenging manufacturing situation. The services PMI at 53.1, while slightly declining, remains very positive, whereas the manufacturing PMI at 43.5 indicates continued contraction in industrial production. However, it does not signal deterioration but rather stabilization at a low level of production. Similarly, in France, there are indications of ongoing challenges in the manufacturing sector offset by stronger performance in services. Italy (PMI composite 51.3) and Spain (55.8) appear to have better prospects.
Nevertheless, the recent positive developments in inflation and interest rates are expected to have positive effects on consumer confidence, demand, and leading indicators during the summer months.
Stabilization of consumer confidence
Despite the initial rate cut by the ECB, household confidence does not appear to be strengthening significantly. This is primarily due to heightened uncertainty in Germany, causing overall confidence to slip slightly in the second quarter. Sectorally, there is improvement primarily in services and consumption, offset by deterioration in the manufacturing and construction sectors. However, as of March, confidence stabilized at its highest level since February 2022, suggesting a potential better appreciation of the situation. Yet, in historical comparison, confidence measured by the European Commission remains well below pre-pandemic levels and its long-term average.
Inflation can still decline
Inflation in the eurozone stabilized between May and June, showing small increases of +0.2%. These positive developments are reassuring observers who were concerned about higher increases of over +0.5% in February, March, and April. The Consumer Price Index (CPI) in the eurozone thus rose by +2.5% year-on-year in June, clearly indicating a significant stabilization of inflation since November 2023. For over two quarters now, overall inflation in the eurozone has been close to the ECB's target of +2%. The statistics from the past two months, showing a limited increase of +0.2% in the CPI, have been sufficient to reassure the European Central Bank of a sustainable stabilization of price levels in the eurozone.
Inflation at the core level remains slightly behind the overall trend, currently standing somewhat higher with a growth rate of +2.9%. However, on the production price front, the situation has accelerated and significantly improved. After reaching a peak of +43% in August 2022, deflation is now clearly established. The indices have recorded over four quarters of year-on-year price contractions, with prices continuing to decline by -4.2% in May, marking six consecutive monthly price decreases. This trend should provide some flexibility for businesses to adjust their selling prices downwards.
The sharp decline in production prices is also expected to continue positively impacting consumer price indices. We anticipate that inflation in the eurozone will further decline in the coming months, though it currently aligns with the ECB's inflation forecast for the year, now set at +2.5%.
The ECB began its rate-cutting cycle in June
After a period of stabilizing its rates and a phase of observation, we believe the ECB could initiate a policy normalization program starting from June 2024, involving a gradual reduction of its key interest rates. The decision to lower rates by 0.25% during its June meeting indicates that the peak of the rate hike cycle was indeed reached in September 2023. The current concern for the ECB is whether the moderation in inflation over the coming months will justify further rate cuts.
Logically, the ECB President has stated it's still too early to determine this due to ongoing uncertainties. European monetary authorities will likely take the summer months for reflection and to gather additional economic data before their scheduled meeting in September to evaluate the possibility of further rate cuts.
In our view, the decline in services inflation must continue to support the ECB's consideration of a rate cut in September. Stabilization of wages is also an important condition that may be more challenging to achieve.
As of June 6, the ECB's main refinancing rate stands at 4.25% following the rate reduction. Considering annual inflation at +2.5%, we still see a significant interest rate differential of 1.75%. The ECB has benefited from a faster-than-expected decline in inflation, but we believe it should lower rates more swiftly to approach the 2.5% to 3% range if inflation continues to decline as anticipated. We expect the ECB to implement two or three more cuts of -0.25% each before the end of 2024.
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Positive outlook for bond markets
If the ECB's key interest rates still significantly exceed the euro area inflation rate, this is no longer quite the case for the longer end of the yield curve and particularly for 10-year bonds.
The yield on German government bonds slipped below 2.4% by mid-June and is now roughly in line with annual inflation. Economic conditions and inflation dynamics have changed significantly since the end of the third quarter of 2023 when euro rates surged to 3%. Recession forecasts that rapidly pushed long-term rates below 2% by the end of the year have been replaced with a new conviction that the euro area will avoid a downturn. Now, it is believed that the trough of the growth slowdown is behind us and the euro area economy is on the path to recovery. In this context, a rebound in long-term rates to 2.7% could be seen as appropriate.
However, we believe that economic momentum will remain weak in 2024 as long as monetary policy does not decisively ease pressure on financing costs. With inflation nearing the ECB's target and monetary policy adjusting downward, the outlook for bond markets appears moderately positive.
This adjustment in long-term rates, which has also occurred across various market segments, seems to once again offer opportunities for investors seeking yield and potential capital gains. However, these gains are expected to be limited.
Yields on Bunds could further decline by 30 to 40 basis points if inflation decreases accordingly, leading to rate decreases for most government issuances in the major euro area countries. Yields in the Netherlands, Italy, or Spain could benefit from a decrease of about 40-50 basis points, potentially resulting in an average capital gain of around +5%. In this context, European bond markets appear attractive once again.
Favorable inflation and interest rate spreads for the euro
In the past six months, the evolution of inflation in the euro area has reshuffled the deck and altered perspectives regarding the exchange rate dynamics. Notably, the collapse in inflation occurred more swiftly in the euro area towards the end of 2023, leading to a sharper contraction in inflation rate differentials. Against the Swiss franc, the inflation differential is now barely 1%, as low as it was before 2022, after reaching a delta of 7%.
Simultaneously, the decline in yields has not been as pronounced, which now positions the relative interest rate differential above the inflation differential. We believe that the euro, which was particularly affected in 2022 and 2023 by the opposite evolution of these parameters, can now rely on this new paradigm to enter a phase of appreciation against the Swiss franc. This environment should support a strengthening of the euro against the franc above parity.
Attractive average yield and price-to-book ratio
After a substantial rebound in securitized real estate in Europe at the end of 2023 (+30%), the first half of 2024 has been characterized by horizontal consolidation in the prices of listed companies. The decline in interest rates and financing costs towards the end of the previous year, followed by an uptick in interest rates during the semester, led to real estate values that had prematurely anticipated a change in monetary policy experiencing short-term profit-taking. After six months of stabilization, securitized real estate investments are now awaiting a more significant shift in monetary policy to resume an upward trend.
At the current level, we anticipate that European securitized real estate will continue to benefit from the upcoming monetary easing by the ECB. We believe the European real estate market offers compelling opportunities in terms of both yield and valuation. With a yield of 5.3%, the EPRA Nareit index for the eurozone ranks favourably globally, yet it still boasts an attractive valuation with a price-to-net asset value ratio of only 80% and a discount of around 200% to book value. European securitized real estate thus enjoys a persistently favourable situation poised for a very positive performance in the second half of 2024. We recommend overweighting asset allocation to this segment, which could potentially advance by +20% in the latter half of the year.
Attractive valuations for European stocks
European stocks rose nearly +10%, benefiting from hopes of ECB rate cuts and a faster-than-expected decline in inflation. However, as the ECB made its first rate cut, the announcement of the dissolution of the French parliament reintroduced uncertainties, preventing European indices from continuing their upward trajectory. From a relative standpoint, European stocks remain attractive in historical valuation terms and compared to their global peers. They still trade at a significant discount compared to U.S. equities.
The valuation of 13.8x earnings for 2024 is lower than the S&P 500's PE ratio of 22.5x. European stocks also appear attractive compared to Japanese stocks (23x), Swiss stocks (13x), and are only slightly more expensive than Chinese stocks (11.3x). The average dividend yield in Europe (3.17%) is also compelling and significantly exceeds that of the United States (1.32%) and Japan (1.61%). They continue to have a strong position in diversified international portfolios in 2024.